1. Introduction

The past six years have seen an interesting dual shift in economics and economic history. Six years ago economists were a highly confident, aggressive, and arrogant bunch. We believed that we understood how modern market economies worked. We believed that we knew how to keep them running with both low and stable inflation and at fairly high levels of prosperity, relative to their technological productive potential.

It happened--as it had always happened whenever economics had thought that they had it figured out--we were wrong.

We were wrong, as we have discovered over the past six years as people attempted to do economic policy, that we had misjudged how to reliably keep economies running at a high level of prosperity. And we had misjudged how to reliably keep economies running at a high level of prosperity because we had misjudged what the Great Depression was. The fact that we had a faulty vision of the Great Depression was a caused of the policy errors and macroeconomic disaster of our day, And the fact that following the policy course that we did did not cure the problems of today has led us to revise our view of the Great Depression. Thus we were doubly wrong, but now--we hope--we have it right.

Our demonstrated wrongness means that a substantial amount of what economists like me were teaching, both about the structure of the economy today and about the Great Depression, was wrong. A consequence of the past six years is that we economists need to rip up a substantial part of our lecture notes--both the modern macro lectures on proper policy during business cycles, and also our economic history lectures about the Great Depression.

Six years ago we economists saw the Great Depression as something the Federal Reserve system could, should, and ought to have stopped dead in its tracks at its beginning. But, we would have said six years ago, the Federal Reserve did not understand the situation, and so it did not act properly. But, we would have said years ago, we today know better. Thus, we would have said six years ago, if anything even remotely Great Depression-like comes down the tracks, we can stop it did. You do not need to worry that we will once again, as in The Great Depression, find ourselves in an economy that is not just depressed but profoundly depressed, and depressed not for a year or two but for more than five--and perhaps more than ten.

That was the subtext of one of the large discussions carried on at the Federal Reserve Bank of Kansas City's August 2005 Jackson Hole Conference. Raghuram Rajan--who has just been named the governor of The Bank of India, India’s central bank--argued that recent changes in financial deregulation had created a situation in which there were too many many cowboys on Wall Street doing too many things and creating too many risks. The general response--from Ben Bernanke and Alan Greenspan, from Arminio Fraga and Larry Summers, and from many many others, from practically everyone speaking to the group in the room save Alan Blinder--was: yes, there are cowboys, and the cowboys will lose money, but their actions will not cause any large-scale damage to the economy. Why not? Because we know well how to build firewalls between financial crises on Wall Street and the real economy of spending on currently-produced goods and services, production, and employment.

Because we know well how to build such firewalls, the near-consensus was, even if the systemically-important financial institutions have lost all control over their derivatives books and taken on immense risks they do not understand, there is no danger to the economy as a whole. Moreover, the argument was, there is value in letting the cowboys continue to do their thing. They might find some interesting business models. They will bear risk--and the world economy as a whole is short of risk-bearing capacity in normal times. Their willingness to bear risk might help accelerate technological progress: the dot-com bubble was a disaster for late-stage investors in venture capital and dot-com equities, but a boon for the rest of us as ten years' of experimentation and investment in high-tech was compressed into three.

Big mistake. Big misjudgment.

We today all listen to Raghu Rajan much more carefully.

2. Perspectives on the Great Depression

2.1. The Perspective of Six Years Ago

As of six years ago, most economists saw the Great Depression of the 1930s in the mirror that the late Milton Friedman and the late Anna Jacobson Schwartz had held up in the "Great Contraction" chapter of their Monetary History of the United States. There were caveats and exceptions. There were dissenters. But the main current of thought was that Friedman and Schwartz had gotten it right, and research and debates were overwhelmingly at the margins--did financial crises have some additional significant non monetary effects, did fiscal policy play somewhat of a role too, were the policies of the Roosevelt administration supply-restrictive? And at the end of their chapter Friedman and Schwartz had a strong message: the Federal Reserve had the technocratic policy tools to keep the economy's money stock growing at a stable rate in the 1930s, and if it had done so there would have been no Great Depression.

And as chair of the Federal Reserve in 2008-10, Ben Bernanke attempted to apply that lesson. He strove to keep the money stock from falling--he strove to keep his people from misinterpreting low interest rates as a sign of monetary ease and flooded the economy with liquidity. Those were the policies that Friedman and Schwartz's work said would have cured the Great Depression easily back in the early 1930’s. But those policies did not work in 2008-10 or, at least, did not work well enough: today we still have a substantially depressed economy--not nearly as bad as the Great Depression, where the unemployment rate rose not by 6% points but by 18% points, but certainly bad enough.

2.2. The Perspective of 72 Years Ago

Back in 1931, as the Great Depression gathered force, the dominant view was that the economy was suffering from a liquidity squeeze. The crashing stock market led people to try to dump stocks for cash--the latest example of something that industrial market economies had seen ever since there had been industrial market economies, starting with the crisis that followed the bursting of the British canal bubble of 1825. The Federal Reserve had been created precisely to deal with such a liquidity squeeze. Its job was to keep interest rates from spiking too high, and if it did its job all would be well, or at least all would be as well as things could be.

Why did people back then believe that--that the job of the Federal Reserve as the Great Depression gathered force was merely to keep interest rates from spiking, and that if it performed that task then all would be well?

The place to start to understand is to backtrack to not 72 but to 220 years ago, and the French economist Jean-Baptiste say.

Jean-Baptise Say had not, originally, wanted to be an economist. He wanted to be a treasury bureaucrat. And in the days of the French Revolution he was in fact doing quite well--special assistant to the finance minister, a rising smart young thing who accompanied the minister around, handed him his papers, investigated things and reported back very quickly. But then his boss was arrested, imprisoned, tortured, convicted, and executed. Jean-Baptise Say somehow kept not only his head but also his freedom and in fact his family’s property. He decides to leave Paris, move out into the countryside, and simply write economics books.

He came up with a doctrine that economists have for 200 years called Say's Law. Whenever somebody sets to work, they do so because they have something in mind that they want to buy. So the very fact that somebody sets to work making stuff means the demand to purchase that stuff is out there somewhere in the system. Thus businesses don’t have to worry in the aggregate that there isn’t going to be enough demand to buy what businesses make in general. There is good reason to worry that people won't demand what you make in particular--if you are making lattes while what people want to buy is yoga lessons, you are in trouble (and the yoga instructors are in clover). But that cannot b true in general, Say argued--for each industry that is depressed, there must be another industry that is booming. It may take quite a while to convert coffee shops to yoga studios and retrain baristas to do the downward-facing dog, and the value of fancy espresso machines may well nosedive causing financial chaos if they are the ultimate support of financial derivatives. But what economists used to call a "general glut"? Not possible, Say said.

Come 1825 people--including Say--discovered that Say had been wrong. When banks are on the point of failing and the network of credit is collapsing, everybody may want to spend less than their income in order to boost the amount of liquid cash money that they are holding. In such a situation interest rates spike: people are willing to promise to pay you back a great deal more liquid cash money in a year if you will let them have your liquid cash money to spend now, and people are willing to let interest- and dividend-paying financial assets go now for a song if you can pay cash right now. In such a situation you need a central bank--like the Bank of England or the Federal Reserve. Because central banks are ultimately backed by the enormous taxing power of the central government, the banknotes they issue are always taken as good as long as their is confidence that the government is not going to collapse and can still impose taxes. So when people want to spend less than they are earning in order to build up the stock of liquid cash money they are holding, it is the job of the central bank to print up banknotes and buy things with them in order to keep employment and production full and in order to create enough liquid cash money in the system that people will once again plan to spend what they earn buying useful goods and services--and note that buying a real property or a piece of producer's durable equipment as an investment for the future is just as much spending as buying a loaf of bread.

The Bank of England did not act quickly enough when the canal boom collapsed in 1825. Come mid-1826 a third of the textile factories in Britain were idle. But the Bank of England learned. And Walter Bagehot laid down his Rule: that in a financial crisis, the central bank must:

lend freely to banks that need more cash in order to satisfy the demands of their depositors to build up their cash holdings.

lend to banks on collateral that is "good in normal times"--that is, lend to the banks that would be sound businesses were there not a crisis and not lend to the banks that are really unsustainable Ponzi schemes in disguise.

lend at a penalty rate so that afterwards those bankers who got themselves into trouble are sorry, and poorer.

keep lending until interest rates return to normal, for when interest rates return to normal you know that there is no longer a liquidity squeeze because people are no longer willing to pay premium prices in terms of money next year or in terms of parting with income-producing property in order to get liquid cash money now.

There was a corollary to Bagehot's Rule. When the central bank does this, it has to properly guard against making people scared there will be too much inflation in the economy--that the credit of the government will collapse, and that ultimately the government will not be able to levy taxes in order to back up the central bank and allow it to retire its excess bank notes once the crisis has passed.

Over 1931 to 1933, as the Great Depression gathered force, the then-Federal Reserve attempted to carry out this set of policies, and President Hoover attempted to back them up. The Federal Reserve lent freely--in fact, it lent over freely, and kept on lending even though the interest rates did not spike. Why? Because even though interest rates were low and thus there was no sign of a liquidity squeeze in financial markets, there were idle factories and unemployed workers and thus signs of a liquidity squeeze in the real economy. "Better safe than sorry", the Federl Reserve thought. And they thought that they needed to do all they could to maintain confidence in the government--which meant maintain confidence in the gold standard. And President Hoover thought that he needed to maintain confidence in the government--which meant trying very hard, by cutting spending and raising taxes, to show that he was trying to balance the budget.

But it did not work. The Great Depression deepened.

President Hoover sought mightily to reduce the budget deficit. He was unsuccessful. This year's spending cuts were neutralized by next year's revenue losses as economic activity fell further. Prosperity was not around the corner. Occasionally the congress would override him and spend more money--as with giving World War I veterans an extra bonus. But the spending was never enough to make for success. From 1929-1933 prices fell at 8% per year. By 1933 if you were a business--well not only did you have 1/3 fewer customers but you were selling everything for on average 1/3 less, and if you had fixed debt charges or other fixed debt charges you were in real trouble.

And all the while, as the Great Depression gathered force, economists disagreed. People like the University of Chicago’s Jacob Vinear walked a path that would later be walked by John Maynard Keynes and Milton Friedman: that the most important thing to do in the Great Depression was to get spending up--to flood the economy with liquidity and, in Keynes's case, if no one else is spending then the government should step up. On the other side were the Joseph Schumpeters, the Friedrich Hayeks, the Lionel Robbins, and company saying: “Wait a minute things have to be more complicated, there have to be deep structural problems in the economy. We need to figure out what those deeper problems are, and solve them. We can't just stimulate the economy!” But they were without a terribly good or coherent idea of what those deeper problems might be. Nevertheless, they had powerful influence in the 1930s, and still have powerful influence today--witness Obama ex-Treasury Secretary Tim Geithner's declaration that "stimulus is sugar", and hence not wroth undertaking.

In the end, recovery from the Great Depression does not begin until countries give up on the combination of the Bagehot Rule and of commitment to sound gold-standard finance. Those countries that have central banks willing to print up enough money so that people are willing to spend it--it is when you adopt such policies that your economy begins to recover. If you don’t, you become France, which sticks to the gold standard all the way up to 1937, and never gets a recovery. When World War II begins, Nazi Germany’s production--equal to France's in 1933--had doubled between 1933 and 1939. French production had fallen by 15%.

2.3. The Monetary History of the United States

And here is where Milton Friedman and Anna J. Schwartz come in, with their 1960s book The Monetary History of the United States. Relative to previous--Bagehotian--doctrines, the central point of the Monetary History is that you cannot tell whether there is a squeeze on the economy just by looking at whether short-term nominal interest rates are high or low. You can have a situation in which people are short of liquid cash money--and thus trying to push their spending below their incomes--and yet also do not want to dump their safe bonds. In such a situation, they also feel like their holdings of safe assets are at or below what they should be. Thus safe interest rates will be low even in a dire liquidity squeeze. You can have a situation in which people are short of liquid cash money and yet also feel that they do not have enough in the way of savings vehicles for the future, and so all interest rates will be low and equity price-earnings ratios high even though there is a dire liquidity squeeze.

The scenario envisioned by Bagehot and company--an excess demand for cash, coupled with an excess supply of labor, currently-produced goods and services, bonds, and stocks--is just one modality of the kind of financial squeeze that can cause a depression.

How then did Friedman and Schwartz say that you could tell that the economy was in a liquidity squeeze, and that the central bank needed to take action?

Look at the quantity of money, they said. That was the innovation of the Monetary History. When the quantity of money in the economy is falling short of its trend, that is the sign that the economy is suffering from a liquidity squeeze, and that the central bank needs to take action by printing money and persuading people--either private-sector of the government--to buy stuff with it.

In the 1960s they carried this message to seminar after seminar and conference after conference, from Stanford all the way up to Cambridge, and from Minneapolis all the way down to Tulane. Their message was that was the Great depression had shown was that the liquidity squeeze doesn’t show itself necessarily as a high rate of interest on treasury debt. What you need to do, Friedman and Schwartz said is look not at prices but at quantities: develop a statistical system to keep track of how much people are holding in the way of currency and bank deposits--money--and watch that very closely. When that starts to fall, the Federal Reserve has to shovel reserves in the system to prevent a fall in the quantity of money. Prevent the fall of the quantity of money, you prevent the liquidity squeeze. Prevent the liquidity squeeze, and you prevent the depression.

In his old age, Milton Friedman moved to San Francisco, near Berkeley, and got a very nice apartment high up in an apartment building with absolutely beautiful view of the Golden Gate. I would have rare telephone conversations and even rarer meetings and coffees with him. And I would taunt him, asking him: "Milton, you are a real believer in the price system, you are a real believer in markets, you are a libertarian, you very strongly think that market prices should tell people what they should do, right? You think market prices are almost always the best indicators of social scarcities. Yet here you are, telling the Federal Reserve that when a depression threatens it should not look at prices but instead it should look at quantities--it should act not like an agent in the market economy but instead much more like the late Soviet Union’s GOSPLAN, focusing on quantity balances. You don’t say that you stabilize the economy by having a National Energy Reserve target a stable number of kilowatt hours delivered. But you do say the Federal Reserve should target a stable quantity of money, deliver a stable amount of liquidity services to its customers. Why?" He would say that banking is different and special. He would say that we are not exactly sure why banking is different, but the fact that every single transaction is funneled through the banking sector is one thing that makes it different.

Thus, in this one industry and in this one industry alone, we do need some quantity-based central planning for the market economy to function properly. But, he would add, that is all we need. Under no circumstance should pinkos like me should be allowed to generalize from the fact that the banking system needs central planning to stabilize the quantity of liquidity services produced to say that there is any presumption for government intervention elsewhere in the economy.

Over the next twenty years Friedman and Schwartz's Monetary History won a near-total nationwide intellectual victory, and then it maintained its dominance up through the mid-2000s. The victory was so complete that Milton Friedman's successor at the University of Chicago, Robert Lucas, told the assembled economists of America in 2003 that they should no longer do business-cycle macroeconomics: that the problem of depression-prevention had been solved, and there were no major issues left to work on. Economists, he said, should go off and study other things--like the determinants of long-run growth:

Macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains… from providing people with better incentives to work and to save, not from better fine-tuning of spending…. The potential for welfare gains from better long-run, supply-side policies exceeds by far the potential from further improvements in short-run demand management… http://pages.stern.nyu.edu/~dbackus/Taxes/Lucas%20priorities%20AER%2003.pdf

Big mistake. In general, whenever economists say that a certain class of economic problems has been solved, do not believe them. And do note that Robert Lucas’s declaration was the third time that economists had proclaimed victory over the business cycle and over depressions: Walter Heller, Lyndon Johnson's chief economist, had said the same thing in the 1930s. And Milton Friedman’s teacher Jacob Viner's teacher Irving Fisher had said the same thing in the summer of 1929 just before the start of the Great Depression--and coupled it with a forecast that because the Federal Reserve now understood its job (and because with Prohibition the U.S. had won the War on Drugs) that "stock prices have now reached a permanently high plateau".

Sometime in your lives some famous economists will say again that a class of economic problems have been solved--maybe of generating healthy long-run growth, maybe of keeping the distribution of wealth from going awry, maybe of preventing depressions. Do not believe them.

In retrospect Robert Lucas’s 2003 American Economic Association Presidential Address was a good "sell" signal for the reputation of the Federal Reserve, and of modern macroeconomists as a group.

3. The Coming of Our Lesser Depression

3.1. Setting the Stage

Back in 2002 Ben Bernanke--then simply a governor of the Federal Reserve, not yet Chair of the President’s Council of Economic Advisers and not yet Chair of the Federal Reserve--doubled down on the Friedman-Schwartz Monetary History interpretation of the Great Depression and its application to the modern economy. AT Milton Friedman's ninetieth birthday party, he said:

The brilliance of Friedman and Schwartz's work on the Great Depression is not simply the texture of the discussion or the coherence of the point of view. Their work was among the first to use history to address seriously the issues of cause and effect in a complex economic system, the problem of identification… they make a powerful case indeed. For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons… The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"…. Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again. Best wishes for your next ninety years. http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/

That was the state of the rather cocky economics profession as of 2007, as storm clouds began to gather.

From 2003-2006, we have a substantial housing bubble. There were furious arguments among economists as to how big the bubble was--or indeed, whether there is a bubble or merely "froth". There were reasons to expect the early 2000s to see a rise in American house prices. Everyone in 2005 saw the industrialization of China as putting a lot of pressure on world energy supplies--that we were never again going to see the real oil prices we has seen since 1986 or before 1979, and that meant that commuting costs were going to be higher. Higher commuting costs mean higher values for houses with short, attractive commutes. Everyone in 2005 saw lower future interest rates as a result of a global savings glut--the rest of the world was getting richer fast, and where do rich people want to put your money? Yes, a lot of them want to put their money in the United States. Supply and demand thus meant that interest rates would be lower in the future, with lower interest rates American homebuyers could qualify for larger mortgages, and that would put upward pressure on house prices as well. Combine those with the fact that the United States seemed to be filling up in a sense that there now seemed to be traffic jams everywhere, then you add a congestion premium to the savings glut premium and the energy-cost premium and so have higher house prices. How much higher were housing fundamentals? That was an unanswered question, and it remains an unanswered question. But there were economists who were claiming in 2006 that all of the rise in housing prices was "fundamental". They were wrong. There was a larger group of economists who said that Federal Reserve and other banking regulator attempts to cool off housing price by interest rate increases or tighter regulations would do more harm than good--they may have been right. And there was a still larger group of economists--in fact, nearly everyone--saying that should the housing bubble crash and bring on a financial crisis, the Federal Reserve will follow the policies that Friedman-Schwartz had determined would have prevented the Great Depression. It would thus build a firewall between whatever happened on Wall Street and the real economy of demand, production, and employment. And we did not need to fear.

The belief was that the financial system was strong and robust, and that anyway the Federal Reserve knew what to do in the event that there did become a big financial crisis. Simply keep the money stock growing smoothly or perhaps a little more aggressively than smoothly, and you build a firewall between whatever financial distress there was and the real economy of production and employment.

That last, very large group was very wrong indeed.

And its view of the world was the view that by then Chair of the Federal Reserve Ben Bernanke adopted as he planned for how to deal with the crisis in 2008-9.

3.2. The Financial Crisis

In March 2008 the systemically-important investment bank of Bear-Stearns came under pressure. Its counterparties on Wall Street were no longer sure that it was solvent, and they were sure that there were many among their fellows who were no longer sure that it was solvent. Reducing your exposure to a Bear-Stearns bankruptcy thus seemed like a good thing to do--and that meant that as it became time for Bear-Stearns to rollover the pieces of the liability side of its balance sheet, it found that it could not do so without offering its counterparties truly usurious interest rates--and if it had to pay those interest rates then Bear-Stearns would be insolvent. And then, one weekend in March, the adverse-selection meltdown took place: the higher the interest rates Bear-Stearns offered to pay on that portion of its liabilities it had to rollover immediately, the less willing were its potential counterparties to lend to it, and it became clear that Bear-Stearns would fail to repay those of its debts due on Monday and would be forced into bankruptcy if nothing was done over the weekend.

Over the weekend, the Federal Reserve and the U.S. Treasury forced the winding-up of Bear-Stearns, guaranteeing its secured and unsecured debt and valuing its equity at $2 a share. Wall Street breathed a great sigh of relief: the U.S. government had just guaranteed the secured and unsecured debt of every systemically-important bank in the United States, and so you no longer needed to shift your portfolio and make provision for how you would make it through a true financial meltdown in which one of the banks at the center of Wall Street simply did not pay its debts one Monday, and everyone to whom it owed money found their wealth frozen temporarily--or lost.

The summer of 2008 passed. And as the summer of 2008 turned into fall it became clear that the ongoing decline in house prices was a bigger problem than had been recognized in March. In March people did roughly the following calculation: 5 million excess houses built using dodgy subprime finance, $100,000 of mortgage debt on each of those houses that was not likely to be repaid, three-fifths of that mortgage debt in the hands of commercial banks and thus guaranteed but the FDIC, two-fifths of that securitized and in the form of MBS CDO's--people owning CDOs were going to get an unpleasant surprise in the form of a loss of $200 billion, although nobody in March was quite sure where that missing $200 billion would turn out to be (but everyone thought Bear-Stearns had a big chunk). By the start of fall 2008 the calculation went differently: not just 5 million excess houses built but 5 million excess houses refinance, and not 3/5 of the losses ultimately resting on the FDIC but 1/5, so that the MBS CDOs that Wall Street had were missing not $200 billion but $800 billion that somebody would have to eat. Thus there was doubt about the solvency of not just one but of many banks: Merrill Lynch, Citigroup--and, most of all, Lehman Brothers.

The argument for making sure that Bear-Stearns had an orderly windup in the spring of 2008 was that the financial system had become fragile. Perceived risks that one's liquid assets in the form of debts owed by or through systemically-important money-center banks might become illiquid and impaired would greatly diminish the demand for risky assets, and lower their price. Since every bank's riskiness depended on the cushion between the value of its assets and the value of its liabilities, and since every bank held risky assets, attempts to make your own bank safer by selling off its risky assets would wind up making everyone's portfolio risky, and trigger another round of fire sales. It was thought in the spring when Bear-Stearns hit the wall, when the total losses to be allocated to Wall Street were thought to be $200 billion of dud MBS CDOs, that it was worth committing the U.S. government's credit as a backstop to prevent a jump to a bad equilibrium. It was thought in the fall, when the losses to be allocated to Wall Street were four times as large, that it was not.

I still have not heard a coherent explanation, either from then-Treasury Secretary Hank Paulson, from then-Fed Chair Ben Bernanke, or from then Federal Reserve Bank of New York President and subsequent Treasury Secretary Tim Geithner, why this reversal of policy: why Bear Stearns was worth supporting in the spring but Lehman Brothers was not worth supporting in the fall when the problem was four times as large. There are claims that the Federal Reserve and the Treasury lacked the legal authority to provide support for Lehman Brothers in September--that its assets were too impaired. If that was the case, it was highly unprofessional for the Federal Reserve and the Treasury to let themselves get boxed into such a position: they certainly had the authority to provide support for Lehman Brothers in July, and if in July they could see that they might not in September, they had a duty to resolve the situation in July. And if they did not see in July that they might not be able to support Lehman Brothers in September--well, then that is still more unprofessional and, in fact, incredible.

The only way to understand the situation that makes sense to me--although neither Paulson, Bernanke, nor Geithner has ever copped to this--is that they jointly concluded in September 2009 that (a) by following Friedman-Schwartz and keeping the money supply on its track they could prevent the financial crisis from having any serious effects on the real economy of production, demand, and employment; and (b) it was time for them to demonstrate to the bankers of Wall Street that if they made stupid loans to over leveraged institutions that they might lose a lot of money, and that the Federal Reserve was not their loyal, tame, and obedient hunting bitch and would not rescue them from their folly.

Big mistake.

Two days later Paulson, Bernanke, and Geithner had recognized that it was a big mistake. They claimed that they did not have the authority to put an insolvent bank, Lehman Brothers, into receivership on Sunday. They assumed the authority to put an equally insolvent insurance company, AIG, into receivership on Wednesday even though Lehman was at the core and AIG only in the penumbra of the Federal Reserve's authority. And the Lesser Depression that started in 2008 was underway…

3.3. The Lesser Depression

As the stock market crushed, interest rates rose, and demand and production and employment collapse, Ben Bernanke put the Friedman and Schwartz plan into effect. He shoveled liquid cash reserves into the system as fast as possible to keep on doing so to keep the quantity of money from declining. And he did so on an awesome and previously unimagined scale.

Take a look at say this graph of the monetary base--the supply of high-powered money that the Federal Reserve is giving to the economy as a whole. Look from 1990 to 2007. You see a change in the rate of growth in 1994, when Alan Greenspan decided that the economy is getting close enough to full employment and he needs to start putting on the brakes to some degree. That change in the slope of the graph, in the speed with which the Federal Reserve was adding to the high-powered money in the economy, produced enormous financial and political uproar, and also produced the last time a president has asked the Chair of the Federal Reserve to come to his office to explain himself. That was a big deal, that change in the slope. You can also see Y2K: the worry back in 1999 that all of these computer programs had been written assuming that the year was a two digit number because years were always in the 20th century, and when it became the 21st century, all kind of programs would fail and piece of the financial system would freeze. The Federal Reserve responded to these worries by giving everyone who wanted extra cash so they’d still be able to buy stuff on January 2nd if things went bad: that is the tiny blip in 2000. And you can also see a panicked rush for cash after September 11th, 2001.

Look at what the Federal Reserve has done starting in 2008. It is simply completely unprecedented. And they have done it again, although on a smaller relative scale, three more times since. Right now the debate inside the Federal Reserve is whether it should "taper": that is a debate over whether the line should continue going more-or-less steeply up, and should flatten out. Milton Friedman and Anna Schwartz’s believe that you should shovel reserves into the system until the whole system was awash in liquidity and so restore the economy to full employment relatively quickly has been tested by experiment since 2008. The answer is: "No."

Certainly our current Lesser Depression is not as bad as the Great Depression was. don’t have nearly as big a decline as you had during the great depression. Employment in non-agricultural establishments fell from 32 to 21 million between its 1929 peak and its 1933 trough--a decline of 31%. Employment in non-agricultural establishments only fell from 138 to 129 million between its 2008 peak and its 2009 trough--a decline of 7%. The decline in the Great Depression was 4.5 times as great and went on for more than twice as long. So we can bet that the Federal Reserve interventions did indeed make things significantly better. But not better enough. Monetary policy turns out to be a partial, not a complete cure--even when undertaken at an extraordinary dose.

Moreover, even though the economy resumes growing after the end of 2009, you don’t see any of the tendency economists used to believe the US economy had to recover to potential. Back in 2006-2008 I gave lectures about how the US has a very flexible market economy with a flexible labor market, how you expect after a recession the economy to get half of the way back to its calculated level of potential output in the course of a year by the normal matching of people with skills with businesses that can use those skills, and that any recession that followed the collapse of the housing boom would be short--that things would be back to normal in three years, tops. It has been five years now. Whatever the rapid full-employment restoring mechanisms we used to think the American economy had--it does not have them now.

The generalization from the Monetary History--the belief that the Great Depression taught us lessons, that those lessons were summarized in the Monetary History, and that following that plan of treatment would keep the economy from falling and remaining significantly below potential--that generalization was wrong. From the perspective of what we thought we knew as a result of the Great Depression, the last five years have been a great surprise.

4. Rethinking Our Understanding of the Depression

4.1. Recapitulation: What We Thought We Knew About the Great Depression

Let me recapitulate, and remind you what we thought we had learned from the Great Depression when we tried to apply its lessons to today, and so bring back to the forefront of your minds the doctrines the failure of 2008-2013 to turn out as we would have expected from the Monetary History has cast into doubt.

Recall that, back in 1931, the Bagehot Rule held that the right way to deal with a financial crisis that would prevent a liquidity squeeze and thus a long depression to allow insolvent banks to fail while rescuing merely illiquid ones--thus keeping the financial system from collapse, and so setting up a situation in which interest rates would quickly return to normal values after the financial crisis was over.

That what was then tried. That didn’t work. By 1980 the lesson drawn from this was the Friedman and Schwartz lesson: the central bank can’t just watch prices, it has to watch quantities. It has to be not just a market actor but a central planner, using the method of material balances, making sure that the supply of liquidity in the economy--its money stock--is at the right level to support a full-employment level of demand. If the Federal Reserve and done that, Friedman and Schwartz claimed, it would have stopped the Great Depression in its tracks. It was the Federal Reserve's failure to act properly that caused the Great Depression. As Ben Bernanke said in 2002: "We did it. We're very sorry. But thanks to you [Milton Friedman and Anna J. Schwartz], we won't do it again."

Friedman and Schwartz were very clear that keeping the money stock on its proper trajectory might well require a central bank to go well beyond the Bagehot Rule. The money stock is, after all, the product of two things: the high-powered money stock which the Federal Reserve creates by buying bonds for its cash--its reserve notes and its reserve deposits at its twelve regional banks--and the money multiplier which is how many dollars of deposits banks are comfortable accepting for each dollar of cash they have in their vaults, plus currency holdings by the public. Keeping the money multiplier from declining may require lending to banks that are insolvent, or lending to solvent but illiquid banks at terms that are not "penalty" terms--both of which are violations of Bagehot's Rule. It was that broader monetarist playbook that Bernanke set out to follow in 2008-9, and, indeed, the decline was over after 18 months, not four years, and the unemployment rate rose by 6% points, not by 18% points.

But the 7% fall in employment is a big deal. And the failure of employment to follow a business-cycle recovery path since is also a big deal. Some hypothesize that the baby boomers have decided to retire early since the labor market is bad, but losses on people's real estate and stock portfolios have been so large that a surprising number of the retired have been unretiring since 2008. The argument that slow employment recovery is being driven by people who want to and are happy retiring rather than by people who cannot find jobs is a non-starter.

Thus our problem: We drew lessons from the Great Depression. We had a theoretical framework we used to understand the Great Depression. We then used that framework to try to understand and deal with today. It didn't work. So we conclude that we badly need to rethink what we thought we knew about the Great Depression.

4.2. How Then Should We Understand the Great Depression?

It wasn’t what Milton Friedman and Anna Jacobson Schwartz thought it was. It wasn't simply the Federal Reserve failure to keep the money stock from declining that did it. Looking at 2009, there seems to be a very strong argument that if the Federal Reserve had in 1931 done what Ben Bernanke did in 2009, it might well have made things better, perhaps significantly better, but it probably wouldn’t have fixed things completely.

As we now see it, what happened in 2008--and what happened in 1931--was not a liquidity squeeze but instead a safety squeeze. People didn't decide that they were simply short of cash and so cut back on their spending, and they would not have pushed their spending rapidly back to normal levels if the Federal Reserve had simply provided the economy with enough cash to make them happy. Instead, people decided that pretty much every financial asset--except for cash, and euros and yen on the one hand, and US and Japanese and German and British government bonds on the other--was too risky. They cut back their spending not because they felt they did not have enough cash but because they did not have enough safety. The depression was the result not of everyone's trying to build up their liquidity but everyone trying to pay down their debt--to deleverage, to move to a safer portfolio. The real problem was not too little cash but too much risk.

This is what Nomura chief economist Richard Koo calls a balance sheet recession. This is what Hyman Minsky--who used to teach at Washington University in St Louis--taught over and over and over again. And Koo's and Minsky's stock stocks have risen substantially over the course of the past six years as we have watched the world economy go through its "Minsky Moment". And a "Minsky Moment" can't be cured by the Federal Reserve expanding the money stock. The Federal Reserve expands the money stock by buying government bonds for cash. It thus adds to the liquidity of the economy. But the cash it sells is no safer an asset than the Treasury bonds it buys--Federal Reserve open-market operations thus do nothing to fix a safety squeeze, they do nothing to help an economy caught in a "Minsky Moment". For that you need to assist in deleveraging, either through loan guarantees or purchases that turn or swap risky assets into or for safe ones, or through running larger government deficits that creates more safe assets--as long as the government debt is not so large that government bonds themselves become risky.

Minsky did not talk much about what to do in a "Minsky Moment". In fact, part of Minsky’s theory was that Minsky Moments were inescapable. The more time passes since the last financial crisis and depression, the more people become willing to take on risks. Portfolios become riskier and riskier, until all over sudden something happens to make people re-evaluate risk. Then risk tolerance collapses, risk perceptions rise, and the economy is back in 2008 or 1929--like 1907, like 1893, like 1873, like 1857.

The substantial reduction of nominal debts due to the inflations of World War II and then of the 1970s did, Minsky think, make the cycle longer this time. But they did not erase it: they just made it longer. Another big crash came, but it came not one generation later--after all the people who had lived through the last crash retired, and after they were no longer around to urge caution on portfolio managers--but two generations later instead.

Minsky is, in fact, quite depressing. The same forces that lead banks and investors to take on excessively risky portfolios also lead legislators to run campaigns as advocates of deregulation and cutters of red tape. Thus in Minsky’s framework attempts to use the government to regulate to prevent overleverage are unlikely to succeed: if you could persuade the government to properly regulate to prevent excessive risk, you could also persuade investors and the banks not to take on too-risky and overleveraged positions.

4.3. Are There Lessons for Today from the Great Depression?

So are there lessons for today from the Great Depression? How did the Great Depression come to an end, anyway?

The first country to pull itself out of the Great Depression is Japan. Under Takahashi Korekiyo, Japan abandons the gold standard, devalues its currency in order to boost demand by making its export industries hyper-competitive and generating an export boom, and embarks on a massive program of armaments so that it can become a full-fledged colonial power and construct what the Japanese government called the Greater East Asia Co-Prosperity Sphere. Bad long-run strategy: getting involved in a land war in Asia and then launching pin-prick attacks on the world's two superpowers, Britain and the United States, is not likely to end well. Good short-run economic policy. As private businesses and households were unwilling to spend as they sought to deleverage, foreign purchasers of Japanese exports and the Japanese government took up the slack. Recovery followed.

The second country to pull itself out of the Great Depression is Britain. Britain abandons the gold standard. The new Chancellor of the Exchequer, Neville Chamberlain, announced that Britain's public finances require a return of the price level to its 1929 levels. Everybody holding safe assets in the form of British Treasury bonds thus notices that there is likely to be about 20% worth of inflation in their near future, this 20% inflation is the equivalent of a 20% tax on safe assets, and so by supply and demand people's as holding onto safe assets becomes more expensive people are more willing to risk holding risky ones. The amount of desired deleveraging thus falls, spending recovers, and recovery follows--but not as fast or as complete a recovery as in Japan or Germany.

The third country to pull itself out of the Great Depression is Germany. Nazi dictator Adolf Hitler takes over in March 1933. Hitler doesn’t worry about balanced budgets or about inflation or about the gold standard. He is happy to freeze prices and wages. He is just as happy to send you to a concentration camp for economic crimes as political ones. And he is very interested in rearmament, because he plans from day 1 to fight World War II to gain Germany the elbow-room he believes it needs in the lands then and now inhabited by Slavic-speakers that he believes ought to be inhabited by Germans. German military spending takes up the slack, and recovery follows.

The fourth country to mostly pull itself out of the Great Depression is the U.S. FDR takes office in March, 1933. He promptly abandons the gold standard. He stops trying to balance the budget. He commits the government to getting farm and other commodity prices up--buying stuff like wheat and corn and steel until prices are up again. And he tries a lot of other things. The U.S. recovery is the weakest.

And France--that never really gets its New Deal at all--brings up the rear in the 1930s.

The conclusions? The direct-spending-by-the-government route appears to work. Ideally, you would like to spend on something other than weapons. The implicitly-tax-safe-assets-by-creating-some-expectations-of-inflation route works. That's what we know about the Great Depression. The keep-the-money-stock-growing route appears to work much less well: that’s what we know about today.

Roosevelt's New Deal--it looks like a net plus, but it is a mixed bag. We have tax, finance, government employment programs, which put people to work under the direction of Harry Hopkins. But we also have policies that take money out the economy and shrink demand, because a lot of New Deal spending was funded by taxes--Roosevelt was always uneasy about budget deficits, especially large ones. We have the NIRA, which gives businesses permission to form cartels. This was the piece of the New Deal that Roosevelt was most excited about in 1933-1934. It might have worked to the extent that it was back-door way of creating expectations of a little more inflation. But Johannes Weiland, who just finished his Ph.D. at Berkeley, seems to have staked that possibility and stuffed its mouth with garlic pretty effectively. You had higher capital and reserve requirements for banks, which are very good things in the long run--but not in the middle of a depression, when you want banks to lend more not less. You have public-utility breakups--and why Roosevelt got himself convinced that the world would be much better if you broke up large networks of public utilities is unclear to me. There is a letter from John Maynard Keynes, the British economist, to Franklin Roosevelt in the winter of 1938 asking: "Why are you doing this? This is a long-run structural policy, but you have dire short-term cyclical problems and that is where you should be spending your political capital." Good question. Good advice.

You have some deficit spending during the New Deal: Roosevelt gives up on Hoover’s belief that it is important to try to balance the budget in the near-term. That did some good. Then there is going off the goal standard and subsequent very rapid expansion of the money supply. There is a strong case pursued especially strongly by my Berkeley colleague Christina Romer that that was genuinely and aggressively helpful--but only once deleveraging was essentiality completed. The New Deal? Maybe two out of seven of its big components were strong positives, one was probably a strong negative, the rest a wash or at best weak positives.

5. Conclusion: What Do We Do Next Time?

So what should be done next time?

There certainly will be a next time. When that comes, we want a government and a Federal Reserve that are able to deal with a balance sheet recession. We have Minsky’s worry: that attempts to prepare beforehand a regulatory framework that will keep there being excessive lending and excessive debt are doomed to failure, because the same forces that lead the bubbles and over leverage also lead on the political side to excessive de-regulation. So "next time" is a very hard problem.

So what should be done right now?

The successful examples of rapid recovery from the Great Depression do say that what you need are:

expectations of somewhat higher inflation

large-scale government deficit spending

There is also (3) the strong possibility that some form of foreclosure relief on the one hand, or rent-to-own, or mortgage refinancing would help. If you look at where the current down turn is deepest, its deepest in places where large numbers of people are scared that their housing equity are gone--that if they have to sell their house they will have to come up with an extra $40,000. Those are the people who aren’t spending but who are frantically trying to pay down their debt the fastest.

But at the moment all three of these--higher inflation than the 2%/year target adopted by Bernanke, bigger short-term deficits in exchange for longer-term entitlement cuts and tax increases, or large-scale fixing of our mortgage financing system--seem politically out of the question.

So before (1), (2), or (3), we need (0): elect a new and very different congress.

But we are not going to. So I believe that we will continue to see the economy continue grow at between 2.5% and 3%/year for the next several years--not a deeper downturn, but no rapid recovery to what we used to think of as normal either.